When the need arises to raise money for your business, you can choose debt financing or equity financing. This article lists the pros and cons of debt vs. equity financing. You'll learn how to choose based on your circumstances.
What is debt financing?
Debt financing means borrowing money to invest in your business. Typically, you borrow from a bank or other lender. Larger corporations might take on debt by issuing bonds.
In either case, you repay the loan's principal and interest on a schedule.
Advantages of business financing with debt
Some advantages of business financing with debt:
- You repay your debt on a regular schedule that fits into your expected cash flow pattern
- Once you repay the debt, you own your business free and clear with no further obligations
- Some of your interest expense may be tax deductible. (Check with your tax advisor because the 2017 Tax Cuts and Jobs Act significantly impacted the conditions under which a business can deduct interest.)
The main advantage of financing your business with debt is predictability. You know the extent and the timing of your obligations, and can plan accordingly.
Disadvantages of business financing with debt
Disadvantages of financing your business with debt include the following:
- Credit can be hard to come by for some businesses, especially start ups
- Repayment generally starts right away. This provides little time for your business investment to generate additional cash flow to meet those repayments
- The regular, fixed payments may become burdensome if your business goes through a down cycle
- Either the business or you personally may have to pledge assets as collateral for the loan
Borrowing to invest in your business reduces the return on your investment. So make sure the investment will at least cover the interest expense.
What is equity financing?
Equity financing means giving up some ownership in the company in exchange for financing. The amount of ownership and the rights accorded with that ownership are subject to negotiation. This depends heavily on the amount of the financing needed and the value of the company.
Advantages of business financing with equity
Here are some reasons to consider financing with equity:
- Financing with equity transfers risk from the company to the investor. The company is not obligated to make any fixed level of payments in exchange for the financing. So repayment depends on the fortunes of the business
- With no immediate payments required, equity financing gives an investment in the business a longer time to pay off
- Not having to make regular payments means no steady drain on the company's cash flow. This can be a big help in the start-up phase and during downturns
Financing a business with equity means bringing on someone who assumes some of the risks with you. That can be easier than meeting repayment obligations.
Disadvantages of business financing with equity
Financing with equity can have some drawbacks, including:
- Finding an equity investor and formulating an ownership agreement is much less straightforward than applying for a loan
- The equity investor will have an ongoing interest in your company. You may have to report regularly to this investor. And you may even have to allow the investor a say in the management of the organization
- If your company is a success, financing with equity will mean having to give up a share of the profits from that success
- While loan obligations are finite, what you give up with an equity stake is open-ended. It continues as long as the investor remains an owner, and the amount of money involved grows with the company's success
All financing involves sacrificing some future profits to meet immediate needs, but this can be especially true of equity financing if your business succeeds.
Assessing the tools
Since both debt and equity financing have their pros and cons, which is better?
As is often the case with business decisions, the merits of debt vs. equity financing are conditions-based. Here are some examples of conditions that can affect the decision:
New vs. established business
For a new business, equity financing can be better, because the company may not have a sufficient history to get credit. Plus, it can take longer for start-ups to generate the cash flow to meet debt repayments.
Your credit history
If you or your business have had credit problems in the past, debt financing may be tough to come by. However if you have a good credit record debt financing should not only be more readily available, but also more cost-effective.
Valuation and interest rate environment
Both interest rates and the degree to which people are willing to invest in private equity go in cycles. A high interest rate environment can make debt financing more expensive. On the other hand, if a slow economy makes people skeptical about investing in an equity stake, you may have to give up too much ownership to get the capital you need.
To a large extent, the debt vs. equity financing decision comes down to how long you think it will take for the new investment in the company to pay off. A quicker payoff period may allow you to meet immediate debt payments and thus you would not have to give up an equity stake in the firm. On the other hand, if you expect it to take a longer time for the investment to bear fruit, taking on an equity investor may give you the breathing room you need.
The good news is that both debt and equity financing can be viable options for a business, and the choice allows you to apply the right method for your situation.